The 10b-5 Daily

Although it has not received much publicity (perhaps due to the fact that it does not appear on the agency’s website), last month the Securities and Exchange Commission filed an amicus brief in the U.S. Court of Appeals for the Second Circuit on the issue of primary vs. aiding-and-abetting liability. The case is the Refco securities class action and the SEC takes dead aim at the Second Circuit’s “bright line” test.

Under the “bright line” test, primary liability only exists if the misstatement is attributable on its face to the defendant. In other words, the defendant must have been identified to investors as the maker of the statement. The SEC argues in its amicus brief that public attribution is unnecessary. Instead, a court should be able to find primary liability when the defendant “creates” the statement, even if investors are unaware of the defendant’s involvement.

Given the long history of the “bright line” test in the Second Circuit, combined with the Supreme Court’s recent emphasis in Stoneridge on the need to establish that investors relied on the defendant’s actions, the SEC’s legal arguments may not carry the day. The SEC seems prepared for this possibility, arguing that even if the Second Circuit keeps the “bright line” test, it should not be applied to government actions (where a showing of reliance is not required).

Quote of Note: “In the Commission’s view, a person makes a false or misleading statement and thus can be liable as a primary violator of Rule 10b-5 when that person creates the statement. A person creates a statement in this context if the statement is written or spoken by him, or if he provides the false or misleading information that another person then puts into the statement, or if he allows the statement to be attributed to him.”
Thanks to Securities Docket for the link to the SEC’s amicus brief.

The U.S. Court of Appeals for the Eighth Circuit does not issue many securities litigation decisions, but it apparently has decided to resolve the few cases it has all at once. For the second time in a week (see here), the court has affirmed the dismissal of a securities class action, although this opinion comes with an interesting twist.

In Horizon Asset Management Inc. v. H&R Block, Inc., 2009 WL 2870505 (8th Cir. Sept. 9, 2009) the court considered whether the plaintiffs had adequately plead a strong inference of scienter (i.e., fraudulent intent) in a case alleging financial misstatements. The opinion contains a few holdings of note:

Internal Investigation – The plaintiffs alleged that the slow pace of the internal investigation once the accounting errors where discovered strengthened the inference of scienter. The court disagreed, finding that it was “prudent” for the company to closely investigate the issue and consult with its independent auditors. Moreover, while the investigation was ongoing, the company publicly disclosed its corporate accounting control weaknesses.

Confidential Witness – The court discounted a statement by a confidential witness that he had been told that senior management was aware of the need for further financial restatements. First, the witness did not state whether his sources had actually spoken with senior management, including the individual defendants, or “merely conveyed hearsay information that was passed along by others.” Second, the reliability of the confidential witness was called into question by another, clearly erroneous statement he had made concerning one of the individual defendants.

Corporate Scienter – The plaintiffs argued that even if their complaint did not raise a strong inference of scienter as to the individual officer defendants, the case should still proceed against the company based on the alleged scienter of another one of the company’s officers. The court declined to address whether this imputation was proper because the plaintiffs failed, in any event, to establish a strong inference of scienter as to the officer in question.

The Eighth Circuit affirmed the dismissal of the complaint, but also addressed an unusual procedural issue. The district court had consolidated the various securities class actions and derivative cases brought against H&R Block into one case. It then named a lead plaintiff who declined to assert any derivative fiduciary claims in its consolidated complaint. When the derivative plaintiffs asked for reconsideration of the lead plaintiff decision, the district court denied the motion, finding that the proposed claims were “not really derivative claims.”

On appeal, the court found that while it was “debatable” whether it was appropriate to have a single plaintiff bring both direct and derivative claims, it was erroneous for the district court to have named a single lead plaintiff who would not pursue the derivative claims the court had previously consolidated. Accordingly, the court reinstated the separate derivative complaints.

Holding: Dismissal of securities class action affirmed. Derivative complaints reinstated.

In the early days of the Private Securities Litigation Reform Act and its new heightened pleading standards, courts regularly dismissed complaints that engaged in “puzzle pleading” (i.e., failed to specify the exact corporate statements that were false and the basis for their alleged falsity). Although plaintiffs quickly learned to be more careful, puzzle pleadings are still sometimes filed and the consequences can be severe.

In In re 2007 Novastar Financial, Inc. Sec. Litig., 2009 WL 2747281 (8th Cir. Sept. 1, 2009), the court considered a complaint against a subprime lender that “over the course of thirty-six pages . . . reproduced, either in their entirety or lengthy excerpts from, nineteen communications-including press releases, SEC filings, and conference call transcripts-issued by Novastar and the individual defendants during the class period that were allegedly false or misleading.” What the complaint did not do, however, is give “any indication as to what specific statements within these communications are alleged to be false or misleading.”

Although the lead plaintiff identified some specific false statements in his appellate brief, the court found that this did not “excuse” the “failure to comply with the pleading requirements under the PSLRA.” The court also agreed with the district court’s decision to deny leave to amend, noting that the lead plaintiff “never submitted a proposed amended complaint to the district court, nor did he proffer the substance of such an amended complaint until he filed his appellate brief.”
Holding: Dismissal affirmed.

Quote of Note: “[E]ven after the district court dismissed [the lead plaintiff’s] complaint and denied his request to amend the complaint, [the lead plaintiff] failed to file a motion under Federal Rules of Civil Procedure 15(a)(2), 59(e), or 60(b), seeking leave to file an amended complaint. As we have noted before, ‘the district court [i]s not required to engage in a guessing game’ as a result of the plaintiff’s failure to specify proposed new allegations.”

Time to catch up on a decision from a couple of weeks ago that might add some incentive for the Supreme Court to take up the issue of foreign-cubed cases. In In re CP Ships Ltd. Sec. Litig., 2009 WL 2462367 (11th Cir. Aug. 13, 2009), a class member objected to the proposed settlement because it covered certain foreign investors, some of whom might be prevented from participating in a related Canadian securities class action brought against the company. CP Ships is a Canadian company whose shares are traded on both the NYSE and Toronto Stock Exchange.

The court found, in contrast to the Second Circuit’s decision in the National Australia Bank case, that the “conduct test” for subject matter jurisdiction was satisfied. Although the false financial statements were issued abroad as in the Second Circuit case, “not only did the manipulation and falsification of the numbers occur in Florida, the executives with responsibility for ensuring the accuracy of the accounting data operated from Florida.”

Holding: District court properly exercised subject matter jurisdiction over the claims of foreign purchasers.

While it may be relatively easy to plead loss causation in the Fifth Circuit, things become a lot more difficult for plaintiffs when it comes time to offer proof. This week, in Fener v. Belo Corp., 2009 WL 2450674 (5th Cir. Aug. 12, 2009), the court considered a case where the corrective disclosure made by the company attributed a decline in newspaper circulation to three separate sources. Only one of the sources, however, was related to the alleged fraudulent conduct.

On appeal from the lower court’s denial of class certification, the Fifth Circuit found that the plaintiff’s expert report was inadequate. Notably, the plaintiff’s expert failed to distinguish between the three different disclosures in conducting his event study, thereby making it impossible to conclude that the alleged fraud caused a significant amount of the post-disclosure stock price decline.

Holding: Denial of class certification affirmed.

Quote of note: “As the district court correctly held, [plaintiff’s expert] testimony was fatally flawed; he wedded himself to the idea that the press release was only one piece of news and conducted his event study based on that belief. We reject any event study that shows only how a ‘stock reacted to the entire bundle of negative information,’ rather than examining the ‘evidence linking the culpable disclosure to the stock-price movement.’ Because [plaintiffs’ expert] based his study on that incorrect assumption, it cannot be used to support a finding of loss causation.”